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STRATEGIC TAX SERVICES


Prohibited Transactions

Exchange Basics

Prohibited Transactions

If the owner's beneficiary of an IRA engages in a prohibited transaction with the account, the account ceases to qualify as an IRA.

The account's earnings will be taxable to the owner as of the first day of the taxable year in which the prohibited transaction occurs.

Prohibited Transactions:

  1. Sale or exchange, or leasing, of any property between the IRA and a disqualified person;
  2. A transfer of real or personal property by a disqualified person to a plan shall be treated as a sale or exchange if the property is subject to a mortgage or similar lien which the plan assumes or if it is subject to a mortgage or similar lien which a disqualified person placed on the property within the 10-year period ending on the date of the transfer;
  3. Lending money or other extension of credit between the IRA and a disqualified person;
  4. Furnishing of goods, services or facilities between the IRA and a disqualified person
  5. Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of the IRA;
  6. Act by a disqualified person who is a fiduciary whereby he deals with the income or assets of the IRA in his own interests or for his own account; or
  7. Receipt of any consideration for his own personal account by any disqualified person who is a fiduciary from any party dealing with the IRA in connection with a transaction involving the income or assets of the IRA.
  8. The above prohibitions extend to family members related to owner-employees and corporations in which an owner-employer holds a 50% or more interest.

Disqualified Persons (defined to include):

  1. A fiduciary;
  2. A person providing services to the plan;
  3. An employer any of whose employees are covered by the plan;
  4. An employee organization, any of whose members are covered by the plan;
  5. An owner, direct or indirect, of 50% or more of
    1. the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation;
    2. the capital interest or the profits interest of a partnership; or
    3. the beneficial interest of a trust or unincorporated enterprise, which is an employer or an employee organization described above;
    4. a member of the family of any individual described above;
    5. a corporation, partnership, or trust or estate of which (or in which) 50% or more of
      1. the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of such corporation,
      2. the capital interest or profits interest of such partnership, or
      3. the beneficial interest of such trust or estate, is owned directly or indirectly, or held by persons described above.
  6. An officer, director (or an individual having powers or responsibilities similar to those of officers or directors), a 10% or more shareholder, or a highly compensated employee (earning 10% or more of the yearly wages of an employer) described above; or
  7. A 10% or more (in capital or profits) partner or joint venturer of a person described above.
  8. For purposes of determining whether the owner owns an ownership interest,
    1. there shall be taken into account indirect stockholdings which would be taken into account under Section 267(c), except that, for purposes of this paragraph, Section 267(c)(4) shall be treated as providing that the members of the family of an individual are the members within the meaning of paragraph (6).
    2. the ownership of profits or beneficial interests shall be determined in accordance with the rules for constructive ownership of stock provided in Section 267(c) (other than paragraph (3) thereof), except that Section 267(c)(4) shall be treated as providing that the members of the family of an individual are the members within the meaning of paragraph (6).
    3. the family of any individual shall include his spouse, ancestor, lineal descendant, and any spouse of a lineal descendant.
  9. the term "fiduciary" is defined by Section 4975(e)(3) as any person who:
    1. exercises any discretionary authority or discretionary control respecting management of such plan or exercises any authority or control respecting management or disposition of its assets,
    2. renders investment advice for a free or other compensation, direct or indirect, with respect to any moneys or other property of such plan, or has any authority or responsibility to do so, or
    3. has any discretionary authority or discretionary responsibility in the administration of such plan.
  10. Penalty tax
    1. While the DOL retains jurisdiction of IRA plans to determine whether an exemption may exist for a potential prohibited transaction, the IRS is not bound by the DOL opinion and may impose the penalty tax and disqualify the plan as well.
    2. Section 4975(a) imposes a 15% tax on the amount involved in the prohibited transaction on the disqualified person involved in the transaction.
    3. Section 4975(b) increases the excise tax to 100% on the amount of the prohibited transaction on the disqualified person involved in the transaction, if the transaction is not corrected within the tax year.
    4. If more than one person is liable under subsection (a) or (b) with respect to any one prohibited transaction, such persons shall be jointly and severally liable under such subsection with respect to such transaction.
    5. The fiduciary is not subject to the tax.
    6. The term "amount involved" means, with respect to a prohibited transaction, the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received. For purposes of the preceding sentence, the fair market value shall be the highest fair market value during the taxable period.
  11. Disqualification of IRA
    1. Prohibited transactions in IRA's have especially disastrous consequences.
      1. If a prohibited transaction occurs, excise taxes, income taxes and loss of the account's tax exempt status as an IRA will result in a substantial economic loss to the retirement savings of the IRA sponsor.
      2. A prohibited transaction involving the individual who established the IRA or a beneficiary of the IRA results in loss of the account's IRA status. Section 408(e)(2)(A).
    2. The law treats the IRA as having made a distribution on the first day of the plan year in which the prohibited transaction occurs. Section 408(e)(2)(B). As a result, the entire balance in the IRA is included in gross income.
  12. Deemed distribution
    The pledge of an IRA as security for a loan is not treated as a prohibited transaction. However, Section 408(e)(4) provides that a constructive distribution takes place in the amount of the account pledged. Exemptions: an IRA owner has obtained an exemption for the cash purchase by the IRA or residential mortgages owned by a partnership in which the IRA owner was a partner. PTE 82-150.
  13. Correction of Prohibited Transaction.
    1. If an IRA, a party in interest, or a disqualified person engages in a transaction in connection with the acquisition, holding or disposition of a security or commodity that otherwise qualifies as a prohibited transaction, an exemption applies to relieve the fiduciary from liability for engaging in a prohibited transaction, if the transaction is corrected within 14 days after the party in interest discovers or reasonably should have discovered that the transaction was prohibited.
    2. This rule does not apply to the acquisition, sale or lease of employer real property.
    3. It also does not apply if any fiduciary knew or should have known at the time of the transaction that it was a prohibited transaction.
    4. A transaction to which this exemption applies is corrected by undoing the transaction to the extent possible and making good to the plan or affected account any losses resulting from the transaction, and by restoring to the plan or account any profits made through the use of the plan assets. Any excise tax imposed under the Code for the corrected transaction will be abated after assessment or refunded or credited after collection. Section 4975(f)(11)(C).

Examples: Fiduciary Prohibited Transactions and Self-Directed IRA's.

Fiduciary prohibited transactions appear to be the most common type of prohibited transaction in the self-directed IRA context. The IRA owner is a fiduciary to a self-directed IRA and cannot use the IRA funds to directly or indirectly benefit himself. The fiduciary prohibited transaction rules are applicable, regardless of whether there is a disqualified person on the other side of the transaction.

  1. The IRA owner directed the IRA to purchase and build at fair market value a high school founded by the IRA owner's brother and sister (who otherwise would not be disqualified persons). The brother and sister were officers and directors of the school. While the sale and leaseback was a non- fiduciary prohibited transaction, a fiduciary prohibited transaction could develop if the transaction benefited the brother and sister of the IRA owner because it could affect the IRA owner's exercise of his "best judgment" as a fiduciary.
  2. The retention of the fiduciary's son to provide administrative services to the plan for a fee. While the statutory exemption for service providers may permit such arrangement, the fiduciary prohibited transaction rules do not.
  3. CCA 201014064. IRA owner should not be allowed to deal indirectly or directly with plan assets for his/her own personal use, and if proceeds from sale of investment of IRA-owned limited liability company are distributed to owner at minimum, Form 1099-R must be issued by IRA custodian.
  4. DOL Op. Ltr. 88-18A . IRA owner of a self-directed IRA made a loan to a corporation in which the owner and related parties owned a 48.14% interest; the corporation was not a disqualified person by the IRA owner had an interest in the corporation that could affect his best judgment as fiduciary; a prohibited transaction involving self-dealing under 4975(c)(1)(D) and (E) "is likely to result" if the loan is made to the corporation.
  5. DOL Op. Ltr. 82-08A . A loan to a corporation in which the IRA owner and his family had a substantial interest might affect the best judgment of the fiduciary and constitute a prohibited transaction under 4975(c)(1)(D) and (E) even though the corporation was not a disqualified person.
  6. DOL Op. Ltr. 93-33A. Involves a sale and leaseback of property that indirectly benefited the daughter and son-in-law of IRA owner, DOL held that even if there were no "family members," sale and leaseback benefited IRA owner's relatives and therefore was prohibited.
  7. IRS Employee Plans Technical Guidance, Prohibited Transactions, IRM 4.72.11.3.6 (June 14, 2002) "If a fiduciary receives any consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the income or assets of the plan, it is a prohibited transaction." (emphasis added).

    *The fiduciary prohibition transaction rules do not permit IRA owners to direct the IRA trustee to enter into any transaction in which the owner has an interest that may affect the "exercise of his judgment as a fiduciary" (the typical conflict of interest situation.)
  8. IRA Purchase of a House / Apartment. Investing IRA funds in a house that is used by the IRA owner (or other disqualified person) for personal use is prohibited. While the DOL has given numerous individual exemptions for transactions involving the sale of real estate between a plan and a party-in-interest, these typically require an independent fiduciary to approve of the transaction. It is not clear that the IRA can pay compensation to the IRA owner for managing the IRA's investment, even if it is found to be reasonable.
  9. Transfers of Encumbered Property by a Disqualified Person to a plan. These transfers are considered to be sales / exchanges for purposes of the prohibited transaction rules. Thus, prohibited transactions include a sale of property that is subject to a mortgage or similar lien, the plan assumes and the transfer of property to the plan by a disqualified person as repayment of an outstanding loan owed by the disqualified person to the plan.
  10. Loans between an IRA and a Disqualified Person. An IRA owner cannot borrow from his or her IRA. An IRA owner may lend IRA assets to a corporation or person who is not a disqualified person or a corporation or person that the IRA owner does not have an interest in, provided such investment does not affect the exercise of owner's "best judgment." Thus, for self-directing IRA's investing in real estate, an IRA owner should be aware that the sale of seller-financed real estate to or by an IRA by or to a disqualified person is prohibited. The origination or purchase to or by the IRA of a mortgage by or to a disqualified person is prohibited. Any loan agreement under which an IRA lends money to a disqualified person to purchase real estate is prohibited. While the DOL has the authority to grant exemptions from loans and other extensions of credit, an IRA owner cannot borrow money from his own IRA. Regarding individual exemptions permitting the leasing of property between a plan and a party-in-interest, the DOL has required the transaction to be on terms at least as favorable to the plan as it could obtain from an unrelated party, as determined by an independent third party. However, a fiduciary may not permit a lease of property from a party-in-interest under this exception if the transaction is made to bail out a failing business at the expense of the plan.
  11. Use of a House / Apartment Owned by an IRA. An IRA owner's (or other disqualified person, such as a child) use of real estate that is a plan asset is prohibited, as it is a "use of a plan asset."
  12. Owner's Pledge or Assignment of an IRA. An IRA may not be assigned by its owner. However, such assignment or pledge does not disqualify the IRA; it is treated as a distribution with respect to the portion assigned or pledged.
  13. IRA's Investment in a Corporation / Partnership in which the IRA owner has some affiliation (e.g., as a current owner, co-investor, employee, creditor, director or officer). Such prohibited transaction issues may arise when the IRA investment initially is made or later. An IRA investment in an enterprise in which the IRA owner and other disqualified person already owns 50% or more, is on its face a prohibited transaction. The IRA and the IRA owner cannot invest 50% equally in a joint venture without triggering a prohibited transaction. In addition, the IRA's investment cannot be made to facilitate or protect the IRA owner's investment in the enterprise. However, the IRA and the IRA owner may form a partnership in which the IRA owner and his or her family own less than 50% of the partnership, provided the IRA owner derives no benefits (other than incidental benefits) from the IRA investment.
  14. Prohibition extended to IRA purchase of interest in family partnership. DOL Adv. Op. 2000-10A.
  15. The DOL rejected a request that a self-directed IRA purchase and lease back land and a building from the participant's daughter and son-in-law. DOL Adv. Op. 93-33A.
  16. DOL Adv. Op. 2006-01A (where self-directed IRA's R and B and individual are investors in limited liability corporation managed by individual and IRA participant R and LLC will engage in lease with S corporation owned by IRA participant B and LLC individual investor, S corporation is disqualified person, lease would amount to prohibited transaction between IRA B and S corporation, and lease might might constitute fiduciary violation by IRA participant B under Section 4975(c)(1)(D) and (E).
  17. Borrowing by its owner from an IRA; See TAM 8849001, ruling that a prohibited transaction takes place when a 401(a) qualified plan participant's personal note to the plan is distributed in kind and then rolled over into an IRA owned by that individual. Following the rollover, the IRA owners would owe the IRA, constituting a prohibited loan between the IRA and a disqualified person, even though the loan was made before the individual established the IRA.
  18. Sales of property by the IRA owner to the IRA, the IRA owner's receipt of unreasonable compensation for managing the IRA's investments, or using the IRA as security for a loan; See also DOL Adv. Op. 2009-03A (4975(c)(1)(B) prohibits granting of security interest in IRA owner's brokerage account to cover debts arising from IRA.
  19. A self-directed IRA owner directing the lending of funds in the IRA to a business he/she owns; DOL Adv. Op. 82-08A

 
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